Lithium Is Crown Jewel for SQM

Through its access to high-quality mineral deposits,

SQM holds just under half of the market share in potassium nitrate, a specialty fertilizer used in high-value crops, including fruits and vegetables. Specialty potash demand should benefit from the shift in emerging-market diets to higher-value foods. While specialty fertilizer prices tend to move in line with commodity potash prices, they have been less affected by movements in commodity potash prices. SQM is also a small player in commodity potash.

SQM is the world’s largest producer of iodine, used in X-ray contrast media, pharmaceuticals, and liquid crystal display films. Global iodine demand has grown 3% annually over the past decade and should grow at this pace going forward as healthcare spending rises with aging populations. SQM is looking to increase its market share through a volume-over-price strategy, which has caused iodine prices to fall, to gain market share that had declined because of new supply.

Cost Advantage Digs Moat We award SQM a narrow economic moat rating based on the company's cost advantage in the production of lithium, iodine, and specialty fertilizers, stemming from its salt brine and caliche ore assets in northern Chile. The salt brines in Salar de Atacama are the lowest-cost source of lithium globally because of the high concentrations of lithium. Likewise, caliche ore is one of world's largest and lowest-cost sources of nitrates and iodine.

Globally, lithium is produced from either lower-cost evaporation of brine or higher-cost mining of spodumene minerals. SQM has a cost advantage in lithium production due to its lucrative brine assets in Salar de Atacama. Two factors make Salar de Atacama the lowest-cost source of lithium in the world: dry conditions and high lithium concentration. Salar de Atacama is one of the driest places in the world and the largest salt flat in Chile. It has an extremely high evaporation rate and low rainfall. Snow from the Andes melts and flows underground into pools of brine, which have the highest concentration of lithium globally. This high concentration makes the company one of the lowest-cost lithium producers even among brine-based producers. The company pumps the brine above ground into a network of large evaporation ponds. Water evaporates from the ponds over the course of approximately 18 months, leaving behind concentrated lithium brine, which is then processed into lithium derivatives, including lithium carbonate and lithium hydroxide for batteries. SQM has a contract through 2030 with the Chilean government to extract 414,369 metric tons of lithium, or roughly 2.2 million metric tons of lithium carbonate equivalent. Additionally, SQM’s joint venture in Australia will become a low-cost lithium hydroxide operation when the spodumene mine and accompanying lithium hydroxide conversion plant fully ramp up by the mid-2020s.

SQM’s caliche ore is the lowest-cost source of iodine globally. Over half of the global supply of iodine comes from caliche ore in Chile, where SQM is the largest producer. Caliche ore is the lowest-cost source due to its high concentration of iodine. Another major source of iodine supply comes from recycling of LCD screens, which is mostly done in Japan. High-cost sources of iodine come from extraction of underground brines as a byproduct of oil and gas production. Altogether, we estimate that roughly 85% of SQM’s gross operating profit comes from products that have a distinctive cost advantage--namely lithium, specialty fertilizers, and iodine. The company’s cost position in potash, which makes up the bulk of the remaining gross profit, is average, but considerably better than high-cost producers in Europe. Because of the high concentrations of potassium in the brines and nitrates in its caliche ore, SQM also holds an advantaged cost position in specialty fertilizers.

While the quality of SQM’s asset portfolio gives the company a considerable competitive advantage because of its low-cost position in various commodities, we award a narrow instead of wide economic moat rating, since the mining rights to Salar de Atacama only run through 2030. Although we are confident that SQM will be able to renew the lease before it expires, former chairman Julio Ponce, the company’s largest shareholder, has put SQM on poor terms with the Chilean government. From 2014 until early 2018, the country was pursuing the early termination of SQM’s Salar de Atacama lease, whose assets made up over half of the company’s 2017 revenue. The two sides went to arbitration but were ultimately able to resolve the dispute once Ponce agreed to relinquish control of the company. If SQM can renegotiate a longer-term lease on Salar de Atacama of at least 20 years, we would consider upgrading our moat rating to wide.

EV Demand Will Dictate Lithium Prices Lithium prices could decline if electric vehicle demand grows more slowly than expected or production takes off too quickly. EV demand could undershoot expectations if fuel cell or other technologies overtake lithium as the most likely power source for next-generation vehicles. Lithium production could ramp up more quickly than demand warrants if producers like Talison, Ganfeng, or Orocobre bring too much supply to the market. Further, SQM's lithium capacity expansions carry project execution risk, especially the spodumene-based operation in Australia, as the company has never operated a hard rock project.

Future potash prices are also uncertain as SQM has no pricing power in the potash market. If new supply from K+S and EuroChem ramps up faster than expected and Uralkali continues to pursue its volume-over-pricing strategy, potash prices could further deteriorate. SQM’s specialty fertilizers, whose prices generally move in line with potash prices over the long term, could be affected by a sustained decline in potash prices.

Although SQM and Corfo, the Chilean government entity that owns Salar de Atacama, recently agreed to a new lease on Salar de Atacama, the lease only runs through 2030 and must be renewed before it expires. Salar de Atacama generates all of SQM’s profits from the lithium and potash segments and a substantial portion of the specialty potash profits. If the two sides are unable to extend the lease, SQM would see a substantial decline in cash flows after 2030.

The Chilean government has set up the National Lithium Commission to assess private-company lithium extraction rights. The commission has floated the idea that the government and private companies form public-private partnerships that share in the value of lithium extraction when current concessions end. SQM’s concession rights should end around 2030, at which time the company may need to give up part of its ownership of its Chilean lithium assets.

SQM is in excellent financial health. The company had a net debt/EBITDA ratio of 0.72 times at the end of 2017. The company ended the year with around $1.25 billion in debt and $630 million in cash. Its EBITDA of $864 million for the period covered its interest payments by over 17 times. Although SQM is likely to issue debt to finance a portion of its future lithium capacity expansions, we ultimately expect these ratios to remain healthy.